The efficient frontier for financial modelling

June 17, 2012

There is a trade off between the explanatory powers of a model and its complexity: the more a model explains, the more complex it will be.

Would you disagree with that?

Before you answer, let me make a claim:

Mathematics is about revealing patterns that simplify.

The mathematician’s work is actually based on producing simplicity, showing how complex problems can be reduced to component pieces that are simpler.

Think about all the beautiful proofs you’ve known. They are beautiful because they have shown how a simple and harmonious vision can achieve a target better than alternatives that will seem like a hack in comparison. Wikipedia explains it well, here.

Read the rest of this entry »

Understanding the credit crisis

June 17, 2012

In an earlier post (see here) I put a link to an online book that explains all the main concepts of economics in terms of the classic ‘Island Economy’.

If you think about it in theoretical terms, this book is a ‘proof’ that the Island Economy is a sufficiently rich model into which many important elements of economic life can be incorporated.

And like all good models, it is light and understandable.

Very importantly, this means that everyone can get involved in a healthy debate about its assumptions & simplifications, and any policy implications coming from it.

This is something that undermines the quality of our mathematical models of financial or economic processes: they require a very large amount of technical ability before you can even start to understand the terms of the model (for derivatives pricing this means stochastic calculus & arbitrage-free pricing theory; for systematic trading this means advanced statistical analysis; for economics this means advanced calculus and plenty of background reading of fragmented economic theories).

Experience tells me that the more technically ‘perfect’ we make our models, the less able the users become of giving an informed critique of the theory’s assumptions and main features.

The lesson I draw from this is that it is the responsibility of the model builders to work even harder to make our theories and models accessible to an averagely intelligent user.

What does this hard work look like?

Well here are four examples:

  1. Irwin Schiff’s book on economics (see my post here).
  2. Ray Dalio’s paper on why economies rise and fall (see my post here).
  3. A series of articles by Isabella Kaminski from FTAlphaville that present the credit crisis in terms of a felt cartoon story about water gathering and storing (see here).
  4. My work on understanding the Black-Scholes formula for out-of-the-money options (see my post here).

Economics book with cartoons, online for free!

May 23, 2012

I’m on a roll with Economics, getting through books and articles at a tremendous rate.

But this one is a gem.

Written by Irwin Schiff (read about him on Wikipedia do), it’s available here as a free-to-download pdf.

His sons Peter & Andrew have published their own version of the story which reflects historical events more carefully. You have to buy that one; I did, it’s good too.

Navigating NewWorldEconomics.com

May 23, 2012

I mentioned in a previous post that I had come across Nathan Lewis’s archive of his articles in NewWorldEconomics.com.

Fascinating stuff, but with so much to read, you need a system of attack.

Mine is here below.

It’s a bit rough, lacks a unifying form, but I think it is worth getting out there already.

I’ll update and shape as I make progress myself.

Read the rest of this entry »

Favourite quotes

May 16, 2012

When you first log-in to Bloomberg in the morning you are greeted by their quote of the day.

Here is a list I will occasionally update with favourites.

“All men who have achieved great things have been great dreamers.”
Orisen Swett Marden

“Acquire inner peace and a multitude will find their salvation near you.”
Catherine de Hueck Doherty

“A finished person is a boring person.”
Anna Quindlen

“All of us, from the cradle to the grave, are happiest when life is organized as a series of excursions, long or short, from the secure base provided by our attachment figure(s).”
John Bowlby

“A mind all logic is like a knife all blade. It makes the hand bleed that uses it.”
Rabindranath Tagore

How to link to sections in Wikipedia

May 15, 2012

A very short post to explain a quick trick I discovered for linking to a specific section in a Wikipedia page.

This works for me in Chrome running on Windows XP.

  1. Visit the section you want to link to.
  2. Ctrl+C the name of the section (ie the section title in the page) you want to link to.
  3. Right click somewhere in the page and choose to View page source.
  4. Search the page for the section name, and just before it you will find something like #Your_section_name which is actually a link.
  5. Click on it, you’ll go to the section, and you can now copy the link address from the address bar.

Irving Fisher’s debt-deflation theory

May 15, 2012

In an effort to make sense of the current chaos, I am ploughing through a collection of readings on economics, and came across a brilliant article by Irving Fisher.

Written in 1933, it lays out his (educated) intuition on the causes and dynamics of debt-deflation cycles.

Frankly it is so fresh it could have been written as recently as yesterday.

You can find it here.

Making neat Excel charts (quickly)

May 9, 2012

If, like me, you spend a lot of time building spreadsheets with charts, you will want to make sure they are all lined up and neat.

This is how I do it. You can get this whole process done in seconds with a bit of practice :-).

  1. Select the range of cells that  you want your chart to cover.
  2. Name it “foo”. You can do that quickly with the keyboard shortcut Alt+i n d (so Alt+i, then ‘n’ and then ‘d’) which brings up the Name Range box.
  3. Use Alt+F11 to bring up your VBA window and select View->Immediate (or use Ctrl+G).
  4. Select the chart.
  5. Paste the following code into the immediate window:
    ActiveChart.Parent.Left = Range("foo").Left
    ActiveChart.Parent.Top = Range("foo").Top
    ActiveChart.Parent.Height = Range("foo").Height
    ActiveChart.Parent.Width = Range("foo").Width
  6. Run each line: put your cursor at the end of the first line and hit Enter to run each line by line.

How do banks work?

May 9, 2012

Nathan Lewis runs a blog called New World Economics, and back in 2008 he wrote a series of 7 articles which do a very good job of explaining how a bank works.

It is well worth a read.

Click here to see the series.

Note that it was written in early 2008, which was about the time when the FED started aggressively cutting their target rate, and strains had already begun to show in the banking sector.

During the boom years, the FED rate had increased steadily from its low of 1% in mid 2004 up to reach 5.25% by early 2006 where it remained until September 2007. Then the FED began a rapid sequence of cuts which had brought the rate down to 3% by Jan 2008, ending the year at 0.25% where it has remained until today.

Just so you know, like.

Project finance funding: a simple Excel model

May 4, 2012

Financing of infrastructure projects is a hot topic at the moment.

Penny Lynch has kindly made a simple cashflow Excel model available which shows the key components (equity vs debt) of project finance funding.

It’s called Simple IRR and DCF Calculations, you’ll find it on this page here (along with lots of other helpful spreadsheets).